How to Calculate Leverage, Margin, and Pip Values in Forex

Although most trading platforms calculate profits and losses, used margin and useable
margin, and account totals, it helps to understand how these things are calculated
so that you can plan transactions and can determine what your potential profit or
loss could be.

Leverage and Margin

Most forex brokers allow a very high leverage ratio, or, to put it differently,
have very low margin requirements. This is why profits and losses can be so great
in forex trading even though the actual prices of the currencies themselves do not
change all that much—certainly not like stocks. Stocks can double or triple in price,
or fall to zero; currency never does. Because currency prices do not vary substantially,
much lower margin requirements is less risky than it would be for stocks.

Most brokers allow a 100:1 leverage, or 1% margin. This means that you can buy or
sell $100,000 worth of currency while maintaining $1,000 in your account. Mini-accounts
can have leverage ratios as high as 200.

The margin in a forex account is a performance bond, the amount of equity needed
to ensure that you can cover your losses. Thus, you do not buy currency with borrowed
money, and no interest is charged on the 99% of the currency’s value that is not
covered by margin. So if you buy $100,000 worth of currency, you are not depositing
$1,000 and borrowing $99,000 for the purchase. The $1,000 is to cover your losses.
Thus, buying or selling short currency is like buying or selling short futures rather
than stocks.

The margin requirement can be met not only with money, but also with profitable
open positions. The equity in your account is the total amount of cash and
the amount of unrealized profits in your open positions minus the losses in your
open positions.

Total Equity = Cash + Open Position Profits - Open Position Losses

Your total equity determines how much margin you have left, and if you have open
positions, total equity will vary continuously as market prices change. Thus, it
is never wise to use 100% of your margin for trades—otherwise, you may be subject
to a margin call. In most cases, however, the broker will simply close out
your largest money-losing positions until the required margin has been restored.

Most brokers advertise leverage ratios, which are usually 100:1 for regular accounts
and could go as high as 200:1 for some mini-accounts. The amount of leverage that
the broker allows determines the amount of margin that you must maintain. Leverage
is inversely proportional to margin, which can be summarized by the following 2
formulas:

To calculate the amount of margin used, multiply the size of the trade by the margin
percentage. Subtracting the margin used for all trades from 100 yields the amount
of margin that you have left.

To calculate the margin for a given trade:

Margin Requirement = Current Price x Units Traded x Margin

Example—Calculating Margin Requirements for a Trade

You want to buy 100,000 Euros with a current price of 1.35 USD, and your broker requires a 1%
margin.

Required Margin = 100,000 x 1.35
x 0.01 = $1,350.00 USD.

Pip Values

In most cases, a pip is equal to .01% of the quote currency, thus, 10,000
pips = 1 unit of currency. In USD, 100 pips = 1 penny, and 10,000 pips = $1. A well
known exception is for the Japanese yen (JPY) in which a pip is worth 1% of the
yen, because the yen has little value compared to other currencies. Since there
are about 120 yen to 1 USD, a pip in USD is close in value to a pip in JPY. (See Currency Quotes; Pips; Bid/Ask Quotes; Cross
Currency Quotes for an introduction.)

Because the quote currency of a currency pair is the quoted price (hence, the name),
the value of the pip is in the quote currency. So, for instance, for EUR/USD, the
pip is equal to 0.0001 USD, but for USD/EUR, the pip is equal to 0.0001 Euro. If
the conversion rate for Euros to dollars is 1.35, then a Euro pip = 0.000135 dollars.

Converting Profits and Losses in Pips to USD

To calculate your profits and losses in pips to your native currency, you must convert
the pip value to your native currency. The following calculations will be shown
using USD as an example.

When you close a trade, the profit or loss is initially expressed in the pip value
of the quoted currency. To determine the total profit or loss, you must multiply
the pip difference between the open price and closing price by the number of units
of currency traded. This yields the total pip difference between the opening and
closing transaction.

If the pip value is USD, then the profit or loss is expressed in USD, but if USD
is the base currency, then the pip value must be converted to USD, which can be
found by dividing the total pip profit or loss by the conversion rate.

Example—Converting Pip Values to USD.

You buy 100,000 Canadian dollars with USD, with conversion
rate USD/CAD = 1.1000. Subsequently, you sell your Canadian dollars for
1.1200, yielding a profit of 200 pips in Canadian
dollars. Because USD is the base currency, you can get the value in USD by dividing
the Canadian value by the exit price of 1.12.

For a cross pair not involving USD, the pip value must be converted by the rate
that was applicable at the time of the closing transaction. To find that rate, you
would look at the quote for the USD/pip currency pair, then multiply the pip value
by this rate, or if you only have the quote for the pip currency/USD, then you divide
by the rate.